The Stock Cycle: What Goes Up Must Come Down

Stock prices may appear random, but there are repeating price cycles, which are predominantly driven by the participation of large financial institutions. Large institutional buying plays out in four distinct phases:

Accumulation

Markup

Distribution

Markdown

A trader must have a strategy to take advantage of price action as it is happening. Understanding the four phases of price will maximize returns because only one of the phases gives the investor optimum profit opportunity in the stock market. When you become aware of stock cycles and the phases of price, you will be prepared to profit consistently with less drawdown.

This phase is not a lucrative time for retail investors to buy, as capital will be tied up, or the investor may experience a large drawdown of capital. However, recognizing the signs of accumulation gives insight to future opportunity. During this phase, price moves mostly sideways in a range. The range is identified by variable pivot highs and lows (Figure 1) and whipsaw-type price movement.

Figure 1: Variable pivot highs and lows and price is sideways. Notice the length of the cycle (green highlight)

Source: TDAmeritrade Strategy Desk

The cup and handle is another price pattern indicating accumulation. The handle is a higher pivot low and may signal the end of an accumulation cycle. A higher high in price above the rim of the "cup" can lead to a new leg up.

Figure 2: Cup-and-handle pattern during the accumulation phase

Source: TDAmeritrade Strategy Desk

The accumulation phase can wear down your capital as price will swing in both directions. Sometimes it is useful to add an indicator to help identify non-trending conditions. The average directional index (ADX) is a trend-strength indicator, and the example in Figure 3 shows price moving sideways. The ADX has been added to show trend strength. An ADX of less than 25 shows low trend strength, indicating non-trending conditions. The ADX rises above the 25 level when there is trend strength. (For further reading about the ADX, see ADX: The Trend Strength Indicator. For background information, see our Exploring Oscillators And Indicators tutorial.)

Figure 3: Accumulation phase - low ADX shows non-trending conditions

Source: TDAmeritrade Strategy Desk

Markup Phase

During the markup phase, price breaks out of range and begins a sustained uptrend. An uptrend is defined as a series of higher pivot highs and higher pivot lows.This stage is when price begins moving up. The big money has established a position and retail investors are now invited to join in the profit party. This is the most profitable time to own the stock - an opportunity to let your profits run. The earlier you can recognize this stage, the more you can profit.

Use trend-trading strategies during this stage. An example of a trend-trading strategy would be to draw a trendline along the pivot lows and stay long above the upward trendline. Entering a stock early in the markup phase leads to the greatest potential profits. Classic trend trading involves entering the stock at pullbacks above the trendline (Figure 4). (Learn how to use trendlines effectively in Track Stock Prices With Trendlines.)

Figure 4: Markup phase. Trends are more likely to continue than reverse, so continue to ride the trend as long as price remains above the trendline.

Source: TDAmeritrade Strategy Desk

The ADX helps us see the transition from the accumulation phase to the markup phase. When the ADX rises above 25 at the same time as a new high in price, the trend may be starting. The best trends will have agreement between the indicator and price, as noted in Figures 5 and 6. The trend is truly your friend; let your profits run. (Check out our Technical Analysis tutorial for more information.)

Figure 5: From accumulation phase to markup phase

Source: TDAmeritrade Strategy Desk

Figure 6: Markup phase, a time of trend

Source: TDAmeritrade Strategy Desk

Uptrends occur in this cycle and price makes higher highs. When trend momentum is increasing, as seen in higher ADX peaks, we can expect the trend to continue. Figure 6 also shows a triangle pattern in the accumulation phase and then a new price high, showing us how the markup phase begins and a trend is born.

The price may continue the trend or enter a reversal; more often than not, the trend will continue after a test of support/resistance.

Rectangle patterns represent price consolidation and can happen when stock shares are being accumulated or distributed. Recognizing the sideways trend leads to the best strategy for profit. An investor can be out of the trade for this period or, if there is a dividend and/or options, another strategy might be to hold and collect dividends and sell covered calls. It is easier to identify in hindsight, but learning to recognize consolidation when it is happening provides an edge in profit trading. (For more, see our Analyzing Chart Patternstutorial.)

Figure 7: Rectangle pattern, price is sideways

Source: TDAmeritrade Strategy Desk

In Figure 7, you can see rectangle price patterns in the markup phase for the Energy Select Sector SPDR (AMEX:XLE), which leads to continuation of the trend as seen in Figure 8. A new high in price from a rectangle pattern is a technical buy signal. A new low in price is a technical sell signal.

Figure 8: Continuation of trend in markup phase

Source: TDAmeritrade Strategy Desk

Distribution Phase

The distribution phase begins as the markup phase ends and price enters another range period. The shares are being sold over a period of time - the opposite of accumulation. This time, the sellers want to maintain higher prices until he or she has sold the shares.

Whether it is distribution or accumulation is less easy to discern at this point. It is more important to be prepared for the next signal, rather than trying to predict the next move.

One of the most common distribution patterns is known as the head-and-shoulders pattern (Figure 9). Rounding or a dome shape (Figure 10) indicates distribution preceding the markdown stage.

Figure 9: A three-pivot reversal, distribution of shares

Source: TDAmeritrade Strategy Desk

Figure 10: Markdown follows distribution

Source: TDAmeritrade Strategy Desk

Markdown Phase

The last phase of the stock cycle is the markdown phase. Markdown begins when price makes a lower high and no new high (Figure 9). Markdown follows distribution, which is when institutions sell inventory, either for redemption reasons, simply taking profit, or to change position into another stock or sector. The markdown phase is a downtrend (Figure 11).

Be careful that emotions do not rule trading during the markdown phase. Price is always the signal to watch; a series of lower pivot highs and lower pivot lows will signal a pullback in price or a trend reversal. A reversal is when price direction changes completely from the direction it was headed. Successful investors ensure that gains are banked, and money-management rules will not allow for holding a declining issue. (Learn to recognize a reversal when it happens in Retracement Or Reversal: Know The Difference.)

Figure 11: Markdown phase is represented by lower pivot highs and lower pivot lows. This is a reversal to a downtrend.

Source: TDAmeritrade Strategy Desk

Figure 12: The stock cycle

Source: TDAmeritrade Strategy Desk

The Bottom Line

The study of stock cycles will give investors the heads-up on trending conditions for a stock, whether sideways, up or down. This allows the investor to plan a strategy for profit that takes advantage of what the price is doing. The entire cycle can repeat or not. It is not necessary to predict it - it is necessary to have the right strategy.

Now you can apply this information to learn to manage risk. Once you have a gain, have a plan to keep some: a gain is not a profit until you bank it. You can use a stop-loss as part of your trade-management plan to help you capitalize on your gains.

Smart investors who recognize the different price cycles are able to take the best profit opportunities. The good news is that you can learn to make the right trade at the right time.